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Insurers are using credit scores to determine whom they sell policies to and at what price. Critics say this is an indirect way for insurers to discriminate racially, which is illegal.
By Liz Pulliam Weston
By law, insurers are forbidden from discriminating on the basis of race or skin color. But recent research indicates such bias may be widespread -- thanks to the advent of credit scoring.
Many insurers use credit information to help determine who they cover and how much that coverage costs. Insurers defend the practice, saying there is a strong correlation between credit scores and claims: the worse the score, the more likely an insured person is to file a claim. Since credit scores only use credit information, not race, insurers insist they aren't discriminating.
The credit-insurance connection
A huge Texas Department of Insurance study recently confirmed the relationship between credit scores and claims. But it also discovered that certain minorities and lower-income populations have worse-than-average credit scores. That means they're getting worse-than-average rates from many insurers, regardless of their claims history, driving record or other factors.
These findings are sure to fuel consumer advocates' fight against the use of scoring in underwriting decisions as unfairly discriminatory.
"I don't know if it's the final word on credit scoring in insurance," said Mike Kreidler, Washington state insurance commissioner and a member of the National Association of Insurance Commissioners' working group studying the issue, "but it is by far the most definitive study that's been conducted."
Further restrictions on credit scoring could, however, wind up boosting rates for the majority of drivers and homeowners who are currently getting price breaks because of their good credit.
About two-thirds of policyholders get a discount on their rates because of good credit scores, according to the Insurance Information Institute, a trade group. Massachusetts' experience could be a harbinger: Rates spiked there after insurers were forbidden to use credit information in their decisions.
Scores vary by race
In most states, so-called "insurance scoring" is commonplace. The Texas study of 2 million policies found that credit scores were used as a factor in 82% of the state's auto-insurance business and 54% of the homeowners' business (both as measured by premiums paid).
The effect of credit scores on premiums varied hugely by insurers. Rates might vary as little as 11% because of credit information or by as much as 400%, the Texas study found. Unlike the lending industry, which primarily uses the FICO model for credit scores, insurers tend to use their own proprietary formulas to determine scores, and each company has its own policies on how those scores are used to set premiums.
Scores also varied significantly by race. The study found that black policyholders had average credit scores that were 10% to 35% worse than those of white policyholders. Hispanics' average scores were 5% to 25% worse, while Asians' scores were roughly the same as whites.
The distinctions are particularly stark when the best and worst credit-score categories were compared:
- Among drivers with the highest credit scores, 90% were white, even though whites represented just 51% of the drivers studied. Blacks comprised 2% of the drivers with the best scores, although they made up more than 7% of the drivers studied. Hispanics represented nearly 19% of the study population but just 5% of the highest-scoring drivers. (The race of 19% of the drivers was unknown.)
- The proportions were nearly equal when the lowest-scoring drivers were compared. Whites made up just 35% of this group; blacks 33% and Hispanics 28%.
Legal forms of discrimination
Credit scores also improved as people's incomes improved, but the evidence wasn't as clear cut. The survey had relatively little data for folks with incomes under $20,000, for example, but those in the "moderate income" category -- with earnings of $20,000 to $32,000 -- were over-represented in the group with the worse credit scores. Credit scores also tended to rise with age, with younger people having worse-than-average scores.
The idea that the young might pay more for insurance is nothing new -- insurers are legally allowed to discriminate against youth, especially when it comes to auto insurance. Young, inexperienced drivers are, as a class, much more likely to be involved in crashes than older folks (although the accident rate per miles driven starts to spike again over age 70). Thus, insurers are allowed to charge them more for liability and collision insurance.
Where you live also has a big impact on how much you pay. Insurers aren't allowed to write off whole neighborhoods of low-income or minority residents -- an illegal act known as redlining -- but they may charge an urban neighborhood more than a less-crowded suburb, arguing that crashes are more frequent where there are more cars, and homeowners' claims more common where the housing stock is older.
Indirect discrimination
What insurers aren't allowed to do is discriminate based on race, no matter how actuarially sound their arguments. Blacks, for example, have shorter life expectancies on average than whites, but companies aren't allowed to charge black customers more for life insurance.
Insurers argue that they should be allowed to use credit scoring because they aren't being intentionally discriminatory. The Texas insurance commissioner, who often sides with the industry, argued in a letter to the state legislature that almost every rating factor used in insurance could be found to discriminate against someone, and urged lawmakers not to act hastily to ban credit-based insurance scoring.
But consumer advocates argue that de facto racial discrimination should not be allowed, no matter how unintentional.
"This report will really fuel the fight" against insurance scoring, predicted consumer advocate Birny Birnbaum, a former Texas insurance associate commissioner and leading critic of insurance scoring. "The question is, are we going to allow the use of a rating factor that does indirectly what you can't do directly?"
Liz Pulliam Weston's column appears every Monday and Thursday, exclusively on MSN Money.
